18-1 Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin.
Monetary Policy Chapter 14 Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights...
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Transcript of Monetary Policy Chapter 14 Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights...
Monetary Policy
Chapter 14Copyright © 2011 by The McGraw-Hill Companies, Inc. All Rights Reserved.McGraw-Hill/Irwin
14-2
The Federal Reserve System
• The Federal Reserve System (the Fed) is the central banking system of the United States
• Created in 1913, it consists of two components:– Headquarters in Washington, D.C.– 12 District Banks
LO-1
14-3
Monetary Policy
• A central responsibility of the Federal Reserve is monetary policy—the use of money and credit controls to influence macroeconomic activity.
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14-4
Figure 14.1
14-5
Federal Reserve District Banks
• The 12 district banks perform many critical services, including the following:– Clearing checks between private banks– Holding bank reserves– Providing currency– Providing loans (called discounting)
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14-6
Figure 14.2
14-7
The Board of Governors
• The key decision maker for monetary policy.
• Located in Washington, D.C• Consists of seven members appointed
by the President and confirmed by the U.S. Senate.
• Board members are appointed for 14-year terms and cannot be reappointed.
• Terms are staggered every two years.LO-1
14-8
The Fed Chairman
• The Chairman is the most visible member of the Federal Reserve System.
• This person is selected by the President for a four-year term and may be reappointed.
• Ben Bernanke is the current Chairman of the Fed.
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14-9
Monetary Tools
• The Fed has the power to alter the money supply through three tools:– Reserve requirements– Discount rate– Open market operations
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14-10
Reserve Requirements
• By changing the reserve requirement, the Fed can directly alter the lending capacity of the banking system.– Required reserves are the minimum
amount of reserves a bank is required to hold by government regulation.
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14-11
• The ability of the banking system to make additional loans (create deposits) is determined by the amount of excess reserves banks hold and the money multiplier:
Reserve Requirements
Available lending capacity of the banking system
Money multiplier
ExcessReserves= x
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• A decrease in required reserves directly increases excess reserves.
• Excess reserves are bank reserves in excess of required reserves:
Reserve Requirements
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Decrease in Required Reserves
• A change in the reserve requirement causes:– A change in excess reserves– A change in the money multiplier
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Table 14.1
14-15
• A lower reserve requirement increases the value of the money multiplier:
• Money Multiplier = 1
Reserve
Requirement
Ratio
Decrease in Required Reserves
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14-16
The Discount Rate
• The discount rate is the rate of interest charged by the Federal Reserve Banks for lending reserves to private banks.
• Sometimes bank reserves run low and they must replenish their reserves temporarily.
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14-17
• There are three sources of last-minute extra reserves:– Federal Funds Market, where banks may
borrow from a reserve-rich bank– Securities Sales– Discounting–obtaining reserve credits
from the Federal Reserve System
The Discount Rate
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14-18
• By raising or lowering the discount rate, the Fed changes the cost of money for banks and the incentive to borrow reserves.
The Discount Rate
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Open-Market Operations
• Open-market operations are the principal mechanism for directly altering the reserves of the banking system.
• Open-market operations are designed to affect portfolio decisions and the decision to hold money or bonds.
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14-20
Figure 14.5
14-21
Hold Money or Bonds?
• The Fed attempts to influence whether individuals hold idle funds in transaction accounts (in banks) or government bonds.
• Changes in bond prices alter portfolio choices.
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14-22
Open-Market Activity
• Open-market operations–Federal Reserve purchases and sales of government bonds for the purpose fo altering bank reserves:– If the Fed buys bonds, it increases bank
reserves.– If the Fed sells bonds, it reduces bank
reserves.
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14-23
Powerful Levers
• To summarize, there are three levers of monetary policy:– Reserve requirements– Discount rates– Open-market operations
• The Fed has effective control of the nation’s money supply.
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14-24
Shifting Aggregate Demand
• The ultimate goal of all macro policy is to stabilize the economy at its full-employment potential.
• Monetary policy may be used to shift aggregate demand.
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14-25
• Aggregate demand is the total quantity of output demanded at alternative price levels in a given time period, ceteris paribus.
Shifting Aggregate Demand
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14-26
Expansionary Policy
• Monetary policy can be used to move the economy to its full-employment potential.
• The Fed can increase AD (by increasing the money supply) by:– Lowering reserve requirements– Dropping the discount rate– Buying more bonds to increase bank
lending capacityLO-4
14-27
• As a result of the near financial meltdown and recession of 2008-09, the Fed took on a massive expansionary policy by expanding its balance sheet (purchasing many government securities and non-government assets) and lowering interest rates to historic levels.
Expansionary Policy
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14-28
Restrictive Policy
• Monetary policy can also be used to cool an overheating economy.
• The Fed can decrease AD (by decreasing the money supply) by:– Raising reserve requirements– Increasing the discount rate– Selling bonds in the open market
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14-29
Interest-Rate Targets
• Interest rates are a key link between changes in the money supply and shifts of the AD curve.
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14-30
Price versus Output Effects
• The success of monetary policy depends on the conditions of aggregate demand and aggregate supply.
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14-31
Aggregate Demand
• Increases in the money supply shift AD to the right.
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14-32
Aggregate Supply
• Aggregate supply is the total quantity of output producers are willing and able to supply at alternative price levels in a given time period, ceteris paribus.
• The shape of the AS curve determines the effectiveness of expansionary monetary policy.
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14-33
• Horizontal AS–output increases without any inflation.
• Vertical AS–inflation occurs without changing output.
• Upward-sloped AS–both prices and output are affected by monetary policy.
Aggregate Supply
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14-34
• With an upward-sloping AS curve, expansionary policy causes some inflation, and restrictive policy causes some unemployment.
Aggregate Supply
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14-35
Figure 14.7
14-36
Fixed Rules or Discretion?
• The shape of the aggregate supply curve spotlights a central policy debate.
• Should the Fed try to fine-tune the economy with constant adjustments of the money supply?
• Or should the Fed instead simply keep the money supply growing at a steady pace?
• The near financial meltdown of 2008 has raised the tone of this debate.
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14-37
Discretionary Policy
• The economy is constantly beset by positive and negative shocks.
• There is a need for continual adjustments to the money supply.
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14-38
Fixed Rules
• Critics of discretionary monetary policy raise objections linked to the shape of the AS curve.
• The AS curve could be vertical or at least upward-sloping.
• With an upward-sloping AS curve, too much expansionary monetary policy leads to inflation.
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14-39
Fixed Rules
• Fixed rules for money-supply management are less prone to error than discretionary policy.
• The Fed should increase the money supply by a constant (fixed) rate each year.– This idea was supported by economists
such as Milton Friedman.
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14-40
The Fed’s Eclecticism
• The Fed currently uses a pragmatic, eclectic approach of:– Flexible rules– Limited discretion
• The Fed mixes money-supply and interest-rate adjustments to do whatever is necessary to promote price stability and economic growth.
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14-41
Inflation Targeting
• Ben Bernanke, the current Fed Chairman, has been a bit more specific about the Fed’s policy.
• He believes the Fed should set an upper limit on inflation (called inflation targeting), then manipulate interest rates and the money supply to achieve it.
LO-5
End of Chapter 14